Of Short Sellers, Forests, Coffee Roasters and the RCMP

Selective involvement by governments in the marketplace muddy the waters of crime and market forces says Sunil Vidyarthi of Investor’s Digest of Canada.

The stock market has its own morality and its own set of guiding principles, even though it may seem as if it’s all about money.

If that were the case, then it’ll simply be bad news if, say, Green Mountain Coffee Roasters Inc. (GMCR) falls 70% in a few weeks. It will simply be a case of missed expectations and bad analysis.

But a similar loss in Sino-Forest Corp. (Toronto: TRE), a Toronto-based timberland play, has prompted the Canadian authorities to launch an investigation into the company.

Mind you, if the past is any indication, by the time the case gets to court an entirely new forest will have sprung up where the company supposedly now has none. Just in case you aren’t familiar with the Sino-Forest story because you were travelling in China, here’s a brief synopsis.

The company claims on its Web site that it has “generated profitable growth since 1994 by cultivating and harvesting trees in a sustainable manner.”

“Sino’s principal businesses,” the Web site continues, “include the ownership and management of forest plantation trees, the sale of standing timber and logs and the complementary manufacturing of downstream engineeredwood products.

From 2005-2010, Sino claims to have averaged compound annual growth rates of 41% in revenue, 24% in diluted earnings per share, and 41% in cash flow from operating activities. The company holds a majority stake in Greenheart Group (094.HK), a Hong Kong-listed company with access to wood fiber in New Zealand and Suriname, South America.

In rhyming off Sino-Forest’s growth rates, I used the verb “claim,” because a few months ago, a self-pronounced US short seller, “Muddy Waters,” charged that all of the company was bogus.

His charge sparked a tumble in Sino’s stock, a company that was once the darling of some of the wisest and smartest folks in business. Even the Ontario Securities Commission got involved, launching an investigation into the company.

Now you know about the only information that’s accurate so far. Everything else, in my mind, is both self-serving and unreliable. If you’ve ever done business outside North America and Europe, what may be considered bribery here passes for sales commissions or fees elsewhere.

Moreover, other than basic math, there’s little in common among global accounting systems. Indeed, even one of Canada’s ex-prime ministers took a big stack of bills in payment for some consulting fee, did he not?

Listen, I’m not trying to justify what’s going on at the sinking forest, I mean Sino-Forest. I wouldn’t dare do that for all the tea (or, is that tree?) in China.

For all I know, these guys at Sino are completely innocent. And the company itself just happened to be an unknown enough name for a short seller to pounce on. In fact, this is the key weakness short sellers prey on.

But in this case, you had one of the largest hedge funds involved with billions in the game. It was actually a household name…if your household connects to Bay Street. [Which Wall Street does, mostly via the New York State Thruway—Editor.]

At the end of the day, Sino-Forest is no better or worse than the humans who control it, or the investors who bet on the information the company makes public. Shouting boo to an unsuspecting person will usually get a response. In fact, a large number of short sellers use that tactic.

Outside the securities industry, such a tactic wouldn’t last too long. If not illegal, it certainly would find services to deal with it, like a boo insurance (or something harsher).

But curiously, in the highly regulated securities industry, you can for the most part say anything—including lies—without fear of harm. With billions of words sloshing around the Net each day, it would be an impossible task to control the quality of information available.

Not surprisingly, bottom-line short sellers are having a field day. Instead of pumping and dumping as of yore, they now first dump and then pump all kinds of rumors.

You may have heard of the efficient market theory. It states that at any time, markets reflect all that is known about the prices of stocks. Well, those who have sold Sino-Forest short, as well as the shares of several other junior Chinese firms, may have found yet another chink in the theory’s armor. After all, the efficient market theory relies on good information, not lies and propaganda.

None of this will help you if you own Sino shares. Fortunately, I took a pass on them some years back, although it was tempting at the time to own trees in China.

Instead, I invested in another Chinese junior, which also now finds itself the target of these trolls. So what is an investor to do? I could crunch the numbers for you, but then I’d be creating another assumption based on a bunch of assumptions that are now being investigated by the Mounties.

Moreover, because trading in Sino-Forest remains halted, your actions are limited. For now, chalk it up to yet another cynical experience in the markets, swear that the efficient market theory is bogus, and that the Nobel laureates who came up with it should donate their prize money to some particular charity.

If it’s any comfort, the chances of Sino-Forest recovering at least some of its losses are much higher than those of Green Mountain, or Krispy Kreme Doughnuts (KKD)—provided, of course, that Sino really does have trees in them thar Chinese forests.

On the other hand, Green Mountain, even after a 70% haircut, trades at 30 to 40 times forecast earnings. Of greater importance, it trades at that multiple at a time when both McDonald’s (MCD) and Tim Hortons (THI) are offering free, or even cheap, cappuccinos.